By the time of the 2008 election, New Zealand had already been mired in our own home-grown recession for nearly a year. A response that would get the economy moving again quickly was clearly needed.

That urgency was reinforced by the global financial crisis that shook the world in the later part of 2008. Our Australian-owned banking system was mercifully affected only mildly by the turmoil, but the increased recessionary pressures across the economy as a whole made it all the more imperative that our new government should act decisively.

We waited in vain for that decisive action. Apart from a largely abortive “jobs summit” in early 2009, the government seemed content to sit out the crisis, waiting for others to bring the recession to an end – and this, despite the buoyancy of our main export markets and a rise to record levels in our main commodity prices.

The government’s main preoccupation was not –so it seemed – to get the unemployed back to work, so that incomes, purchasing power and demand would rise. They focused instead on government debt – surprisingly since, at just 23.4% of GDP, New Zealand’s government debt was one of the three or four lowest in the OECD.

They asserted that – successful though the Labour government had been in bringing that percentage down – it was now their main focus to get it down further. Only in that way, they believed, would confidence return, recovery from recession be achieved, a credit downgrade be avoided, and interest rates be held at low levels.

In expressing such faith in what the Nobel prize-winning economist, Paul Krugman, calls the “confidence fairy”, our government was following down a track mapped out by the leaders of other Western countries – those same leaders who had presided over the global financial crisis in the first place.

Let’s be clear. Manageable levels of government debt are clearly desirable. The question is not whether that should be the goal, or at least one of them, but rather whether the government’s chosen method of achieving the goal has been effective.

Three years later, how have we done? Did the “confidence fairy” appear and work her magic? The answer is sadly disappointing.

Despite the priority they had, the government’s finances remain in a parlous state. As Brian Gaynor pointed out recently, the government’s cumulative deficit over three years will rise to $35.5 billion, compared to a surplus of $35.6 billion under the Labour government. As a result, government debt will rise to 37.7% of GDP. Why has this happened?

The answer is really a matter of common sense. The main drag on government finances is the loss of revenue in an economy that refuses to grow out of recession – and, as this week’s figures show, still does. You don’t solve that problem by slowing the economy still further, by cutting what could have been a sensible investment in getting the economy moving again.

The government, in other words, backed the wrong horse. If they had concentrated on getting people back to work, so that they earned and spent more, the economy would not only have been more buoyant, but so too would government revenues. The deficit may have been higher in the short term, as the investment in our future was made, but it would not have been so persistently high now and over the longer term. Cutting government deficits does not promote recovery; it is the other way round.

Not only has the government failed to control its own deficits and debt. It has also increased the country’s debt, with the result that we have suffered the credit downgrades the government warned against, while the interest rates we pay to overseas lenders will rise.

It is cold comfort to know that we have not been alone in making these mistakes. In many other Western countries, the expected appearance, in response to austerity and cutbacks, of the “confidence fairy” has not materialised. The Conservatives in Britain, the eurozone’s leaders, the Republicans in the United States, have all pinned their hopes on austerity – and, as those hopes have been dashed, their only self-defeating remedy is to inflict yet more pain.

The “confidence fairy” seems unimpressed by more blood-letting, to which the nearest analogy is the use of leeches by medieval doctors to bleed their sick patients.

We may feel sorry for the Greeks or Italians, but we have suffered the same dead-end policies that they have had to endure – albeit, given the size of the eurozone economy, on a smaller scale.

We, too, have been driven by ideological tunnel vision down a one-way, no-exit road, unable to go forward or back – not a comfortable situation with a second recession bearing down on us.

And, in case the we try to blame our lamentable performance on the global financial crisis or the Christchurch earthquake, let’s be clear that our government blew its best chance of pulling us out of recession well before the full impact of those factors was felt – a point not depending on hindsight but made by me and others at the time.

If the exodus across the Tasman is to be stemmed, we surely cannot afford another wasted three years.

It is a measure of how subdued is the national mood and how modest are our current ambitions that we expect so little of our elected governments. Even nearly four years after our own home-grown recession began, we are, for example, expected to acclaim as a triumph of economic management the first signs of a patchy and fitful recovery that still leaves us well short of 2008 levels.

We might have expected much better. We were largely insulated from the direct effects of the global financial crisis. Our two major export markets remained surprisingly buoyant. And we have enjoyed record high commodity prices.

Yet, to hear our leaders tell it, even our woes are a sign of success. The soaring kiwi dollar, we are assured, shows that foreign investors see us as a “safe haven” – a claim that sits oddly alongside the repeated warnings about the risk of a credit downgrade and of the need to wind back public spending so as to reduce a rampant government deficit.

The truth is that the soaring dollar reflects a conviction on the part of overseas speculators – based on 25 years of experience – that our governments will go on paying them a premium and that the short-term demand for our currency thereby engendered will produce a capital gain as well.

This is entirely consistent with the growing evidence that, as the recovery at last manifests itself, we will use the opportunity to repeat the recurrent mistakes of the past 25 years all over again. We will continue to treat any prospect of growth as an inflationary threat, to be knocked on the head by a combination of high interest rates and an overvalued currency. We will continue to express puzzlement as to why – in this policy framework – productivity languishes and our economic performance falls behind that of our competitors.

There are occasional flickers of interest in a change of policy. Geoff Simmons, for example, points to the prospect of using tighter rules for bank lending as a counter-inflationary tool and as an alternative to high interest rates. But he also warns that the Reserve Bank – with its single focus on inflation (and it is, after all, a bank) – is unlikely to change course.

And governments, of course, particularly at this stage of the electoral cycle, may wring their hands at the high dollar, but will secretly welcome the consequently cheaper imports – a short-term advantage that helps to holds down a soaring cost of living through to election day but that is bought at a huge cost to our long-term economic performance.

It could be said that these problems are like old friends; they may be a nuisance and somewhat boring, but they are at least predictable, and it is true that there is a certain comfort to be drawn from getting what you expect. A right-of-centre government could be expected, for example, to stick closely to monetarist theory, and to pin its hopes for an improvement in economic performance on tax cuts for the well-off, asset sales, cutting government spending, taking a tough line on benefits, and seeking free-market solutions to most problems.

That is exactly of course what we have got and presumably what people voted for. In the past, after giving these measures a fair trial, they have judged that they have not worked and then voted to get rid of them. This time, the policies look like surviving for a little time yet. It is not that the policies are different – merely that the salesman is better.

But there is one consequence of current policy that even the most brilliant salesmanship cannot so easily sell to the public. The now unmistakable evidence of rising poverty, with children as the most vulnerable victims, is the inevitable result of widening inequality, higher unemployment, falling real incomes for the poor, less effective public services, and rapidly rising living costs.

The myth that families choose poverty as a lifestyle option can only be sustained in a society that is divided – where the well-off are comfortably shielded from the realities of life for the worse-off.

One of the advantages of being well-off is that it is possible to buy your way into a better neighbourhood, to go to better schools, to mix with better-off work colleagues and friends.

You do not then need to venture into the poorer neighbourhoods, to sit around the table to share inadequate and poor-quality food or to feel the cold and damp in overcrowded bedrooms. You do not feel the humiliation of being rejected for job after job or having to present yourself for close questioning as the condition for receiving a weekly benefit which – in a well-off family – might be entirely spent on a single meal for family and friends at a good restaurant.

Individual instances of hungry children might be dismissed as cases of fecklessness and inadequate parenting. But a rising tide of such children, whose health, education and very lives are threatened by hunger, is a social phenomenon with widespread social and economic causes. It might be – indeed, is – a predictable consequence of current policies, but that, surely, does not make it acceptable? Predictability in this case should not produce resignation but rather a clarion call for action.

There are times when one can’t help feeling sorry for the government. After two years of framing economic policy to please the credit rating agencies – last year’s budget was virtually dictated by Standard and Poor’s – their reward has been a warning last month that our credit rating is on negative watch.

That blow has been followed by the revelation that the government’s deficit has blown out by $2 billion more than forecast. This intrusion of economic reality may not be welcome but it has been salutary.

The government’s response so far to these twin developments has been to maintain a stiff upper lip, and to continue to target a return to surplus by 2016. Others have not been so restrained. The air is thick with urgings – from the Reserve Bank, the Treasury, the Business Roundtable, and not least the Herald’s own leader-writers and columnists – that the government’s deficit must be cut and cut faster.

It is hard to see these warnings as anything more than a knee-jerk reaction to what people think they heard, or wanted to hear. They see or purport to see a substantial connection between the threatened downgrading of our credit rating and the size of the government’s deficit.

A careful reading of Standard and Poor’s statement, however, reveals that the government’s deficit (which remains perfectly manageable by international standards) played only a minor part in their expression of concern about our credit rating. Their focus was on the country’s external deficit – our propensity to finance an inflated consumption by borrowing from overseas.

It is true that the government’s deficit is an element in the country’s overall deficit but it is not the element that is of particular concern to S&P. What worries them – and they are quite explicit about this – is that, if and when a substantial recovery finally materialises, our appetite for imported consumer goods will re-emerge with a vengeance and we will be back to our bad old habits of borrowing to finance a persistent trade deficit.

The real import of their warning is that they see nothing in our current policy settings to suggest that we will avoid this all too familiar outcome. They fear that any revival in economic activity will see the application of the decades-old “remedy” of high interest rates leading to a yet higher dollar, with consequent damage to savings and exports while we binge on artificially cheap imports. Sooner or later, they warn, the willingness of overseas lenders to fund this rake’s progress may be exhausted.

But, say the deficit hawks, the external deficit, our poor savings record, and the narrow base of our export sector – all of which are fingered by S&P as causes for their concern – are problems for the future. Surely – whether S&P say it or not – the one thing the government can do to help is to get its own deficit down faster than planned, even if that means painful cuts that might impact the most vulnerable?

Let us be clear. All other things being equal, it would clearly be beneficial for the government to eliminate its deficit as soon as possible. And the government is quite right to seek savings in respect of public spending that may be wasteful or poorly directed.
But if cutting the deficit is the first and over-riding priority, we need to be sure that it would produce, in today’s context, the desired outcomes – and it is a pity that this realisation did not dawn before the government’s finances were further weakened by tax cuts that mainly benefited the better off.

But there is no evidence that simply taking the axe to government spending would help matters. The main reason for the government’s increased deficit is that tax revenue – already depressed by the recession – is much lower than forecast, and that in turn is a direct consequence of the slowness of our economic recovery. To cut government expenditure, thereby further depressing demand and eventually tax revenue, is not the most obvious solution to this problem.

The paradox is that, as many of us warned at the onset of the recession, the greater the priority and urgency given to cutting the deficit, the more persistent it is likely to be. The most effective course for a government worried about its deficit is – while maintaining proper controls over potentially wasteful spending – to play its part in ensuring that the level of economic activity rises.

As it is, we are in danger of getting caught in a downward spiral. Our export income is being depressed by the high dollar. The consumer is facing higher fuel and energy prices and the threat of continuing job losses, and uses any margin of spending power to pay down debt. The business sector is struggling with inadequate demand and therefore keeping tight tabs on employment and investment plans. If the government, too, cuts its spending further, where is recovery to come from? And how do we ensure that recovery, when it comes, does not take us straight back – as S&P warn that it will – to the problems that have dogged us for decades?

As the world-wide recession seems to be bottoming out, one question is being asked with increasing frequency and urgency. Have we learnt the lessons so that it will not happen again?

The answer – at least in the US and the UK – is not a reassuring one. As the hard-pressed taxpayer, already burdened with the threat to homes and livelihoods, is left to pick up the bill for market failure – a bill in the billions which will not be paid for years, not to say decades – those whose recklessness and greed caused the crisis have already returned to the bad old ways.

We see the same outrageous bonuses, the same disregard for prudence, the same confidence that the price of failure will always be paid by someone else. It is almost as though the publicly financed bail-out has provided the fat cats with a renewed belief in their own infallibility, by convincing them that they will always be protected because they are too big and too important to be allowed to fail.

In New Zealand, where the financial sector is too small to exhibit these attitudes, we have nevertheless seen our own somewhat paradoxical response to market failure. It might have been thought that, in an economy where public finances had been unusually well and prudently managed over recent years, the public sector would be the last place that would be required to bear the brunt of recessionary retraction.

In other countries (notably Australia), and in line with the revival around the world of Keynesian insights into how to respond to recession, the public sector has been seen – not as the problem – but as an important part of the solution. We, however, seem to have become obsessed with the size of the government deficit, which is still relatively low in historical and international terms, with the result that the salami slicer has been applied with very little discrimination across the whole range of public spending.

No one can cavil at an increased drive to ensure value for money in public spending. The suspicion must remain, however, that the recession has been a not unwelcome excuse to rein back the public sector on ideological rather than economic grounds.

There is, however, a more significant respect in which we seem to have decided not to apply the lessons we should have learned. We should not forget that we have been in recession since the end of 2007 – long before the financial crisis broke. That home-grown downturn was the direct consequence of the policy directions we had been following for 25 years having finally run into the buffers.

Inflation then was still enough of a worry to lead the Governor of the Reserve Bank to keep interest rates at an internationally very high level. That in turn, through pushing up the exchange rate, had destroyed the competitiveness of our industries, created a current account in serious imbalance, increased our need to borrow to finance the gap between what we earned and what we spent, pushed up the exchange rate and stoked inflation still further as “hot” money flowed in to take advantage of the high interest rates, and so on round an increasingly vicious circle.

As we contemplate the post-recession scenario, those fundamental problems are no nearer solution. Indeed, some are a good deal worse; the overvalued dollar is destroying our productive economy with every day that passes. Our only response to these pressing problems seems to be that “there is nothing we can do.”

But there are things we can do. We could acknowledge that the strategy of defining macro-economic policy in exclusively monetary terms, and of directing the whole force of that policy to the single goal of controlling inflation, using a single instrument in the hands of a single unelected official, has failed – both as an effective way of controlling inflation, and in terms of its disastrous impact on our overall economic performance.

If we want to do better, and in particular, if we want to raise our poor productivity levels, we have to do things differently. If we go on with the same policy prescriptions as we have applied for the last 25 years, we will get the same disappointing results as we have endured over the last 25 years.

What is needed is a fundamental shift in perspective. It would mean, in line with the revival of Keynesian thinking, re-defining macro-economic policy so as to include the whole range of fiscal as well as monetary measures. It would mean setting the goals of macro policy (including interest and exchange rates) in terms, not of inflation, but of competitiveness, as the Singaporeans do. It would mean, rather than clobbering the whole economy with a poorly focused counter-inflation strategy, continuing the battle against inflation with specific micro measures directed at defined inflationary pressures, such as excessive bank lending and the favourable tax treatment of housing, and encouraging saving by strengthening the incentives to save.

It probably won’t happen. It is amazing that an orthodoxy that has been so thoroughly discredited by experience still has such a hold on official thinking. The government might be encouraged, however, to undertake an “agonising re-appraisal” by the thought that a change of tack might produce a better outcome, not least for their own pet preoccupation. Nothing, after all, would do more to get the government deficit down in a hurry than a newly buoyant economy.

The global recession dominates the thinking and writing of the world’s best economists – and not surprisingly, they exhibit a wide range of views as to what is really happening. There is not even a consensus about how deep and how long the recession will be, let alone what should be done about it.

In New Zealand, we are now reaching a more sober assessment of how we will be affected. After an early period that was somewhat akin to a “phoney war”, we are now beginning to realise that the worst may be yet to come.

We must of course be careful to avoid undue pessimism. Deflation feeds on itself, as people prepare for hard times by battening down the hatches and thereby make the times even harder. But we must also be alert to the policy measures that could help – and there is at least an emerging consensus that the earlier such measures are put in place, the more effective they will be.

We also know now that the “jobs summit” – however well-intentioned – may have succeeded in creating a sense of pulling together but has not managed to produce much by way of measures to stop the slide into further recession. If we are to be effective, we need to decide now on what needs to be done.

The time may be right, in other words, to rehearse the arguments for government intervention. Virtually all of the world’s economists agree that the central feature of recession, and of threatened depression, is a deficiency of demand or purchasing power. In New Zealand, we are being hit by a double whammy in this regard; our export markets are contracting at the same time as unemployment and a deflated housing market mean that consumers at home are also spending less.

Left to itself, an economy will take a long and damaging time to correct this deficiency. But, it will be asked, what can governments do about this, when their own finances are being hard hit by recessionary factors? And if the government spends money it doesn’t have, isn’t this just building up problems for the future?

Our own Treasury is not immune from this kind of thinking. Its projections show – even without further interventions – a sharp rise in the government deficit in the next year or so, and they then extrapolate that rise so that the deficit appears to soar into the stratosphere over the next decade. This, they say, means we should be cautious about boosting government spending further.

This is not, however, an accurate way of looking at the issues. There is a good deal of evidence, supported by a growing number of economists, that the key is timing. A dollar spent now to boost the economy could save several dollars in government deficit later on.

The argument runs as follows. The government deficit rises and falls in line with the fortunes of the economy as a whole. A buoyant economy will generate a large tax revenue so that -as has happened over recent years – the deficit can actually be reduced by paying off debt. A flat or shrinking economy, on the other hand, will increase the deficit, as the government struggles to maintain essential services with falling tax revenues; and if the government does respond by trying to cut the deficit by spending less, this will make matters worse by dragging the economy even lower and making the deficit bigger in the long term.

If, on the other hand, the government has the courage to intervene now with carefully judged spending so that economic activity is boosted, the recession will end sooner and government finances will improve quicker. What might look like a frightening short-term deficit may well be the best protection against a bigger deficit in the long term. The priority is to spend the government dollar now, when it is most needed and will be most effective in correcting what would otherwise be a growing deficiency of demand.

Government spending now would of course depend for its efficacy on exactly what it was spent on. If increased government spending went mainly on consumption, little would have been achieved; that is why many believe that tax cuts are not necessarily the most effective means of boosting the economy and countering the recession.

If, on the other hand, the government spends now on investment projects that will strengthen our economy in the long term, we not only counter the current recession effectively, but will be better equipped to prosper in the future. Investment for this purpose need not be limited to physical facilities in areas like transport, communications and energy, but could also include programmes for improving our research effort and the skills of our people.

The ideologues and the faint-hearted will quail at the sight of a rising government deficit at this particular juncture. But common sense is our best guide. We are all familiar, in our personal lives and in our businesses, with borrowing now to invest in a more prosperous future. Let’s do it for our country too.